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Thursday, October 28, 2010

ECRI Warns of High Inflation Nightmare From QE2

ECRI Warns The Fed's QE2 May Cause High Inflation Nightmare

The Economic Cycle Research Institute, ECRI - a New York-based independent forecasting group, says there will be no double dip recession and Fed's planned QE2, a second round of quantitative easing, could lead to unintended "worse nightmare" of high inflation. (More about ECRI)

"That is the message from leading business cycle indicators, which are unmistakably veering away from the recession track, following the patterns seen in post-World War II slowdowns that didn't lead to recession."

After completing an exhaustive review of key drivers of the business cycle, ranging from credit to inventories and measures of labor market conditions, we can forecast with confidence that the economy will avoid a double dip.

But ECRI warned there is bad news for growth and jobs

But the bad news is that a revival in economic growth is not yet in sight.

The slowing of economic growth that began in mid-2010 will continue through early 2011.

Even worse, the Fed could be behind the curve yet again with QE2 leading to unintended inflation down the road.

The problem with QE2. The worse news is that, even without the nightmare of a new recession, an uglier scenario may still lie ahead in the form of unintended consequences of such Fed stimulus.

ECRI warns that the Fed, using its rear-view mirror indicators, may be goosing the economy with an inflationary stimulus program when it isn't needed and worse, just before the economy could get better.

Because monetary policy acts with "long and variable lags," the Fed should, in principle, rely on forward-looking measures to time its actions. Yet, in practice, it does pretty much the opposite, relying on backward-looking statistics like core inflation and hard-to-assess measures of the so-called output gap, including estimates of "full employment."

In mid-2003, the last time "core" inflation was this low, the Fed cut rates to just 1% and kept it there for a year, contributing in no small measure to the inflation of the housing bubble that ended so disastrously.

In fact, the Fed is about to launch QE2 because it believes inflation to be too low, which really means they are willing to go to new extremes to head off the risk of deflation. Yet, over the last two centuries the U.S. economy has seen sustained deflation only when it has mostly been in recession -- a scenario that our analysis rules out for now.

If the Fed goes ahead with its planned QE2 program, then the question for us investors will be "where is the next bubble forming?"

Today, the car that is the U.S. economy is crawling uphill, slowing as its engine sputters. With politicians fighting about whether to use a screwdriver or a spanner wrench to fix the motor, the Fed is convinced we'll end up using neither. Determined not to let the car start rolling back disastrously downhill, yet unaware that the road is about to level off, the Fed is strapping an untested rocket onto the car in hopes of blasting it over the top.

The Fed, looking out the rear-view mirror to steer the car, won't know when we're approaching a bend in the road, though we're now high up in the mountains, with a dangerous abyss below.

If the Fed goes ahead with its planned QE2 program, then the question for us investors will likely be "where is the next bubble forming?" The very high returns for my individual TIPS and TIPS funds (FINPX Charts and VIPSX Charts) these past two years plus the large gains in gold (Gold Charts and Quote) and commodities, despite low CPI inflation, might be signaling what lies ahead.